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Excluding Part of the Gain From the Sale of a Residence

A
portion of the gain from the sale of a principal residence can
be excluded when the taxpayer fails to meet the requirements
for full exclusion of gain (i.e., the ownership and use
requirements or the one-sale-in-two-years requirement) when
the primary reason for selling or exchanging the principal
residence was a change in place of employment, health, or
unforeseen circumstances (Sec. 121(c); Regs. Sec.
1.121-3(b)).

As noted
below, safe harbors are available for each of the three
situations. If the taxpayer meets the safe harbor, the sale is
deemed to be by reason of that event. However, taxpayers who
do not meet a safe harbor can still qualify for a partial
exclusion if they demonstrate that one of the three qualifying
situations was the primary reason for the sale or exchange.
The following may indicate that an event or circumstance was
the primary reason for a premature home sale (Regs. Sec.
1.121-3(b)):

A short time between the sale and the circumstances
giving rise to it;

The property’s
suitability as the taxpayer’s principal residence
materially changes;

The taxpayer’s financial
ability to maintain the property is materially impaired;

The taxpayer used the property as a residence
while he or she owned it;

The circumstances
giving rise to the sale were not reasonably foreseeable
when the taxpayer began using the property as the
principal residence; and

The circumstances
giving rise to the sale occurred while the taxpayer owned
and used the home as a principal residence.

Observation: If taxpayers meet one of the safe harbors (described
later), the safe-harbor event does not have to be the
primary reason for the sale (although the primary purpose
test must still be satisfied if a safe harbor is not met)
(Regs. Sec. 1.121-3(b)).

The
partial exclusion is based on a fraction, which is multiplied
by the maximum allowable exclusion (i.e., $250,000 for a
single filer or $500,000 for married filing jointly). The
numerator of the fraction is the shorter of: (1) the period of
time the taxpayer owned the property during the five-year
period ending on the date of the sale or exchange; (2) the
period of time that the taxpayer used the property as the
taxpayer’s principal residence during the five-year period
ending on the date of the sale or exchange; or (3) the period
of time between the date of a prior sale or exchange of
property for which the taxpayer excluded gain under Sec. 121
(Regs. Sec. 1.121-3(g)(1)). The numerator of the fraction can
be expressed in days or months. The denominator of the
fraction is 730 days or 24 months (i.e., two years), depending
on the measure of time used in the numerator.

Example 1: S sells her residence on Sept. 1 and excludes $245,000 of
gain. She buys a new house on the same date. On Dec. 1 of
the same year, she moves to accept a promotion in a state
400 miles away. She sells the house on Oct. 1 of the
following year for a $50,000 gain.

S can exclude part of the gain even though she did not
own and occupy the house for two years and it has been less
than two years since she used the exclusion. Because the
move was due to a change in place of employment, S is allowed a partial exclusion. She owned the house for
395 days (i.e., 13 months), occupied it as a residence for
91 days, and at the time of sale it had been 395 days since
she last used the exclusion. The shortest of the periods is
91 days, so she is entitled to an exclusion of up to $31,164 ((91 ÷ 730) ×
$250,000 maximum allowable exclusion). While S can exclude $31,164, the remainder of the gain would be
taxed as long-term capital gain.

Change in Place of Employment

The
change in place of employment test is met if the primary
reason for the sale or exchange is a change in the location of
the employment of a qualified individual (Regs. Sec.
1.121-3(c)(1)). A qualified individual is the taxpayer, the
taxpayer’s spouse, a co-owner of the property, or a person
whose principal place of abode is in the same household as the
taxpayer (Regs. Sec. 1.121-3(f)).

Under a
distance safe harbor, the primary reason for the sale or
exchange is deemed to be a change in place of employment if
(1) the change in place of employment occurs while the
taxpayer owns and is using the property as a principal
residence; and (2) the individual’s new place of employment is
at least 50 miles farther from the residence sold or exchanged
than was the former place of employment, or, if there was no
former place of employment, the distance between the
individual’s new place of employment and the residence sold or
exchanged is at least 50 miles (Regs. Sec. 1.121-3(c)(2)).
Employment includes commencing employment with a new employer,
continuing with the same employer, and commencing or
continuing self-employment.

Observation: The safe-harbor test uses the same mileage guidelines
that apply when determining if moving expenses are
deductible under Sec. 217.

Example 2: A buys a condo in February that is five miles from her
place of employment and uses it as her principal residence.
In December of that same year, A, who works as an emergency medicine physician, obtains
a job that is located 51 miles from her condo. Because she
may be called in to work unscheduled hours and, when called,
must be able to arrive quickly, A sells her condo and buys a new one that is four miles
from her new job. Because her new job is only 46 (51–5)
miles farther from the old condo than her former job, the
sale is not within the safe-harbor rule. However, A is still entitled to the partial gain exclusion for the
sale since, under those facts and circumstances, the primary
reason for the sale is the change in her place of
employment.

Health
Reasons

The
health reason test is met if the primary reason for the sale
or exchange is to obtain, provide, or facilitate the
diagnosis, cure, mitigation, or treatment of a disease,
illness, or injury to a qualified individual (Regs. Sec.
1.121-3(d)(1)). A qualified individual includes the taxpayer,
the taxpayer’s spouse, a co-owner of the property, or a person
whose principal place of abode is in the same household as the
taxpayer, and any of the following family members of these
individuals:

A sale
or exchange that is merely beneficial to the general health or
well-being of the individual does not qualify. Under a
safe-harbor rule, a change in residence recommended by a
physician (as defined in Sec. 213(d)(4) for medical deduction
purposes) qualifies as a health reason (Regs. Sec.
1.121-3(d)(2)).

Unforeseen
Circumstances

An unforeseen circumstance is the occurrence of an event
that the taxpayer could not reasonably have anticipated
before purchasing and occupying the residence (Regs. Sec.
1.121-3(e)). Under a safe harbor, the primary reason is
deemed to be unforeseen circumstances if any of the
following events occur during the period the taxpayer owns
and uses the property as a principal residence (Regs. Sec.
1.121-3(e)(2)):

The involuntary conversion of the property.

Natural or man-made disasters or acts of war or
terrorism resulting in a casualty to the residence
(without regard to deductibility under Sec. 165(h)).

Any of the following in the case of a qualified
individual (as defined earlier for the
change-of-employment test): (a) death; (b) cessation of
employment as a result of which the individual is eligible
for unemployment compensation; (c) a change in employment
or self-employment status that results in the taxpayer’s
inability to pay housing costs and reasonable basic living
expenses for the taxpayer’s household (including food,
clothing, medical expenses, taxes, transportation,
court-ordered payments, and expenses reasonably necessary
for the production of income, but not for the maintenance
of a luxurious standard of living); (d) divorce or legal
separation under a decree of divorce or separate
maintenance; or (e) multiple births from the same
pregnancy.

An event
the IRS designates as an unforeseen circumstance in published
guidance of general applicability or in a ruling directed to a
specific taxpayer. However, taxpayers may rely on only those
determinations made by the IRS in published guidance of
general applicability, and a ruling directed to a specific
taxpayer does not establish a safe harbor of general
applicability for other taxpayers. Examples of events
designated as unforeseen circumstances in rulings directed to
specific taxpayers include:

A probation officer’s recommendation to move to
avoid harassment from neighbors and to increase the
taxpayer’s chances of reducing probation and house
arrest (Letter Ruling 200403049).

Criminal activities in the neighborhood, including
assault and threats to the taxpayer’s son (Letter Ruling
200601009).

The taxpayer’s move to the school district where her
children attended school after taxpayer remarried and
moved into the new spouse’s home (Letter Ruling
200601022).

A move to a new home where the taxpayer’s child and
grandchild could also live, due to the child’s changed
circumstances (divorce and unemployment) requiring her
to move back into her parent’s home (Letter Ruling
200601023).

The need for a larger
home to facilitate an adoption (Letter Ruling 200613009).

The need for a larger home to accommodate a
blended family upon marriage (Letter Ruling 200725018).

Example 3: N buys a house that
she uses as her principal residence. The property is located
on a heavily trafficked road. N sells the house nine
months later because the traffic is more disturbing than she
expected. N is not
entitled to a partial gain exclusion because none of the safe
harbors apply, and the traffic is not an unforeseen
circumstance because N could have reasonably
anticipated the traffic problem when she bought the house.

Example 4: Assume
instead that N
purchased a house on a bystreet that was not well-traveled.
However, two months after she purchased the home, road
construction on a major nearby street detoured traffic through
her neighborhood, causing excessive noise. N was not informed about
the upcoming road construction when she purchased the house.
The excessive traffic is an unforeseen circumstance because
N had no reason to
expect traffic conditions to change so quickly (see Regs. Sec.
1.121-3(e)(4), Example (5)).

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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